**5. Integrating climate-related risks into credit risk assessment**

There are two approaches for integrating climate-related risks into credit risk assessments. On the one hand, there is a risk approach whose objective is to integrate a new source of risk in order to accurately measure credit risk and assumes that a risk differential between green and brown assets exists; on the other hand, there is an economic policy approach, aiming to foster the transition to a lowcarbon economy by shifting credit from brown to green activities [42].

Under the risk approach, the risk-weight factor is recalibrated for all categories of assets to identify the differential due to climate-related risks. The differential should be taken into consideration when determining pricing and capital requirements. When the objective is to adjust capital requirements as an economic policy tool to allocate credit to specific sectors, the accurate level of climate-related risks is not a central concern anymore. This approach rather focuses on channeling credits to facilitate the transition toward a low-carbon economy. The objective is to foster transition by introducing a financial incentive through the capital adequacy regulation without following a risk reasoning [42].

Climate-related risks are expected to be included in all relevant stages of the credit-granting process and credit processing. Specifically, institutions are expected to form an opinion on how climate-related risks affect the borrower's default risk. The climate factors that are material to the borrower's default risk of the exposure are expected to be identified and assessed. As part of this assessment, institutions may take into consideration the quality of the clients' own management of climaterelated risks. They are also to give appropriate consideration to changes in the risk profile of sectors and geographies driven by climate-related risks [28].

In quantifying, evaluating, and factoring climate-related risks into credit risk assessment, institutions require risk indicators or ratings for their counterparties that take into account climate-related and environmental risks. This is achieved by identifying borrowers that may be exposed, directly or indirectly, to increased climate-related risks. Critical exposures to such risks should be highlighted and,

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*Climate Change, Credit Risk and Financial Stability DOI: http://dx.doi.org/10.5772/intechopen.93304*

measures including pricing [28].

**1. Defining climate scenarios**

"The estimation of the impact of climate change and of the transition to a low-carbon economy on credit risk relies first on the definition of physical scenarios for climate change and for the transition. These scenarios define how climate change will impact the variables that are relevant for economic activities, how a transition will mitigate these impacts and which measures are taken to steer

into financial risk metrics.

the transition."

**Table 1.**

**6. Climate change and financial stability**

where applicable, considered under various scenarios with the aim of ensuring the ability to assess and introduce in a timely manner any appropriate risk mitigation

Counterparty credit scoring requires detailed sectoral and geographic metrics to interpret climate-related risks as a view of financial vulnerability, taking into account mitigation measures. The resulting risk score can be used to inform credit decisions and to create a portfolio overview. The score can also be embedded in

**2. Estimating economic and financial** 

"Once the impact of climate change on the variables relevant for economic activities has been estimated, its consequences must be translated into economic terms though macro and microeconomic simulations. This step basically assesses the direct and indirect repercussions of climate change and the transition to a low-carbon economy in economic terms and identifies which actors are affected by them and by how much. Once the economic effects on actors have been identified, the next step is to estimate the impact of these effects on both their cash flows and their balance sheets."

**3. Translating financial impacts into credit risk measures**

"Based on this assessment of financial impacts on firms and households, the next step is to compute how changes in cash flows and balance sheets will affect their credit worthiness in terms of probability of default and loss given default – and thus also in their credit ratings."

For better integration of climate-related risks into credit risk assessment, Monnin [30] advocates addressing the limitations of historical data; expanding the horizon of credit risk models; finding the right level of data granularity; identifying the relevant climate-related risk exposure metrics; and translating economic impact

*Steps for integrating physical climate risk into credit risk assessment processes [44].*

Estimates of the aggregate economic impacts of climate change and the costs of mitigation both vary widely and are highly dependent on factors such as core assumptions, model design, sectoral coverage, and scenario selection [45]. On the one hand, available estimates suggest that physical damage from climate change could reach one tenth, or even one fifth, of global GDP by the end of this century, with considerable uncertainties around amplifying dynamics. In terms of current global output, this would amount to USD 8–17 trillion. On the other hand, some estimates suggest the transition to a low-carbon economy will require investment of between USD 1 trillion and USD 4 trillion in constant terms when considering the energy sector alone, or up

Dietz et al. [46] employed standard integrated assessment model (IAM) and the climate value-at-risk (VAR) framework to quantitatively investigate the physical impact of climate change on the financial system. They found that without mitigation efforts, physical risks related to climate change could lead to a loss of USD

to USD 20 trillion when looking at the economy more broadly [11].

internal and external climate-related risk reporting (**Table 1**) [43].

**impacts**

where applicable, considered under various scenarios with the aim of ensuring the ability to assess and introduce in a timely manner any appropriate risk mitigation measures including pricing [28].

Counterparty credit scoring requires detailed sectoral and geographic metrics to interpret climate-related risks as a view of financial vulnerability, taking into account mitigation measures. The resulting risk score can be used to inform credit decisions and to create a portfolio overview. The score can also be embedded in internal and external climate-related risk reporting (**Table 1**) [43].


#### **Table 1.**

*Banking and Finance*

lower leverage in the post-2015 period.

Literature establishing the link between climate change and credit risk is growing. Kleimeier and Viehs [33] show a significant and negative relation between CO2 emission levels and the cost of bank loans. Delis, De Greif, and Ongena [34] observe that banks appeared to start pricing climate policy risk after the Paris Climate Agreement, while Ginglinger and Quentin [35] find that greater climate risk leads to

Capasso et al. [36] investigated the relationship between exposure to climate change and firm credit risk and found that the exposure to climate risks affects the creditworthiness of loans and bonds issued by corporates. Similarly, Delis et al. [34] demonstrated that climate policy risk is priced in syndicated loans, especially in sectors related to fossil fuel. Jung et al. [37] provided evidence of the existence of a positive association between the cost of debt and carbon-related risks for firms. Rajhi and Albuquerque [38] submitted that natural disasters are predictive of higher nonperforming loans and higher likelihood of default in developing countries. Battiston et al. [39] found that while direct exposures to the fossil fuel sector are small, the combined exposures to climate policy-relevant sectors are large, heterogeneous, and amplified by large indirect exposures via financial counterparties. Ilhan et al. [40] showed for a sample of S&P 500 companies that higher emissions increase downside risk—the potential losses that may occur if a particular investment position is taken. Monasterolo and De Angelis [41] indicated that investors

require higher risk premia for carbon-intensive industries' equity.

tion without following a risk reasoning [42].

**5. Integrating climate-related risks into credit risk assessment**

There are two approaches for integrating climate-related risks into credit risk assessments. On the one hand, there is a risk approach whose objective is to integrate a new source of risk in order to accurately measure credit risk and assumes that a risk differential between green and brown assets exists; on the other hand, there is an economic policy approach, aiming to foster the transition to a lowcarbon economy by shifting credit from brown to green activities [42].

Under the risk approach, the risk-weight factor is recalibrated for all categories of assets to identify the differential due to climate-related risks. The differential should be taken into consideration when determining pricing and capital requirements. When the objective is to adjust capital requirements as an economic policy tool to allocate credit to specific sectors, the accurate level of climate-related risks is not a central concern anymore. This approach rather focuses on channeling credits to facilitate the transition toward a low-carbon economy. The objective is to foster transition by introducing a financial incentive through the capital adequacy regula-

Climate-related risks are expected to be included in all relevant stages of the credit-granting process and credit processing. Specifically, institutions are expected to form an opinion on how climate-related risks affect the borrower's default risk. The climate factors that are material to the borrower's default risk of the exposure are expected to be identified and assessed. As part of this assessment, institutions may take into consideration the quality of the clients' own management of climaterelated risks. They are also to give appropriate consideration to changes in the risk

In quantifying, evaluating, and factoring climate-related risks into credit risk assessment, institutions require risk indicators or ratings for their counterparties that take into account climate-related and environmental risks. This is achieved by identifying borrowers that may be exposed, directly or indirectly, to increased climate-related risks. Critical exposures to such risks should be highlighted and,

profile of sectors and geographies driven by climate-related risks [28].

**80**

*Steps for integrating physical climate risk into credit risk assessment processes [44].*

For better integration of climate-related risks into credit risk assessment, Monnin [30] advocates addressing the limitations of historical data; expanding the horizon of credit risk models; finding the right level of data granularity; identifying the relevant climate-related risk exposure metrics; and translating economic impact into financial risk metrics.
